Capital Gains

Which Point on the Star Applies to Your Client?
Understanding the basics of capital gain taxes starts by picking a point on the star. Often real estate transactions are closed without considering the potential of capital gain taxes to the seller. Of course, as the attorney for the seller in residential sales, we seldom see the contract or seller before it is signed; but, in those that we do or in those non-residential sales when we get the opportunity to advise before the property is listed or the contract is signed, it is important to make sure the client is aware of the capital gain implications.

In Residential Sales, the gain on single-family residences is excluded from income up to $250,000 of gain for the single taxpayer ($500,000 on joint returns in most situations), if the taxpayer has lived in and owned the residence as the personal abode for two out of the last five years. However, a partial exclusion may be available under safe harbors or special circumstances approved by the IRS for taxpayers who do not meet the two out of five-year rule or who previously sold another home within the two- year period. No gain or loss is recognized on transfers between spouses or incident to divorce.

This exclusion only applies to the residence portion. So, in the sale of a two-family in which the taxpayer also resides or on a farm sale with a residence, only the portion occupied as a residence qualifies for the exemption. It is also important to recognize capital gain implications since the gain on many residences is rapidly exceeding these exclusions amounts.

Where capital gain is being recognized in a sale, one should be aware that

  • recapture of depreciation is at the recapture capital gain rate of 25% for federal plus 3% for the State of Illinois;
  • long- term capital gain rate is normally 15% (plus 3% for Illinois) but may be lower.
  • recognition of capital gain can be delayed by using a 1031 like-kind exchange.

If the taxpayer meets certain requirements – 2005 ordinary income lower than $16,400 for joint returns and a capital gain of less than $59,000 – the gain may be taxed at a lower rate of 5%. These income limitations gradually increase for inflation in subsequent years, and recent tax law (the Tax Increase Prevention and Reconciliation Act of 2005 [TIPRA] passed in 2006) decreases the lower income capital gain tax rate to 0% for tax years 2008 – 2010, if the limitations are met. Thus, advising your client to delay a sale or at least take installments under the limitations may make sense if you have low-income taxpayers. Remember, spreading out the income in installments may have other adverse effects; e.g., making Social Security payments taxable over several years instead of only one year.

Section 1031 exchanges delay the tax but do not eliminate it. However, if the seller can repurchase like-kind property within the §1031 rules and dies holding that exchange property, the basis will jump up to the value at time of death and taxpayer’s beneficiaries would escape without any capital gain as well as recapture tax. Also, if you have more than one parcel being sold, including two or more contiguous tax parcels, you might think about doing a separate contract for each parcel. This could give the seller more flexibility in naming replacement properties within the 45-day regulation requirements.

Attorney Donald L. Shriver
and Debra Gay, CPA